Investment returns are exponential as well. So instead of intuition, let’s visualize what is at stake.

Let’s compare investing $100k in the stock market with a generous 10% yearly return vs 25%, over 20 years.

That’s a huge difference! $673k vs $8.7M.

If there is one time to not be intellectually lazy, this is it. So let’s take a closer look.

Is the Risk Priced In Rental Property Returns?

When someone says the risk is priced in, they are stating that the reason the returns are greater is because it is balanced out by the risk of losing money.

Imagine a roulette wheel with 36 numbers and no zero. Betting on red, black, even, or odd pays 2 to 1. Betting on a single number pays 36 to 1.

Of course betting a single number has much greater returns, let’s bet there!

Not so fast bucko – it comes with more risk. You will lose so often that it balances out – your expected rate of return is exactly the same as betting red.

Back to rental properties. If you state the risk is priced in without calculating anything, you are stating a belief in the efficient-market hypothesis.

What is the Efficient-Market Hypothesis?

Without getting too technical, it states that all information is priced in relative to risk in an efficient market.

The $20 bill intro ran through some comedic extrapolations of the efficient-market hypothesis.

In other words if I see something that is too good to be true (free $20) in an efficient market (out there in public), there is either information I’m missing that others know (feces) or risk I’m not accounting for correctly (hurt back).

You could state that I had an information advantage – I saw the $20 bill. The whole market didn’t have access to that information, just me.

In other words, believers in the efficient-market hypothesis think it is possible to generate higher returns accounting for risk, but you need some sort of advantage.

I challenge you to not be mentally lazy and just assume the risk is perfectly priced in to rental property returns. Here are some of the advantages that let you generate greater returns.

Advantage 1 – Your Effort

It is a pain in the butt purchasing real estate.

You don’t just go on E*TRADE and a few clicks later have your $20k invested.

No no no – it takes at least a month involving piles of paperwork and lawyers. The good news is it has been done before many times and is fairly mechanical after you have done it once.

But the really good news is that this keeps people out. Their laziness is your gain.

Advantage 2 – Government Encouragement

A tax code and other policies are basically a set of incentives designed to encourage certain actions from the populace.

The US government encourages individuals to own rental properties by handing out free money. It’s up to you to take advantage of it.

There is obvious tax stuff like deductions on real expenses like interest payments and fake expenses like depreciation.

Even better – a whole government agency is set up to provide cheap leverage to investors. Leverage is how you can achieve such incredible returns. (And it can be safe. Not trying to time a market like Miami, rather going for slow and steady boring cities with jobs like Memphis. See: The Thing Most Investors Don’t Understand About Leverage)

Usually only banks and big corporations have access to investment leverage like this. This is the one area an Average Joe can do it. Wahoo!

It is way affordable too. The interest rate on a credit card is around 20%. If you get a personal loan or a small business loan, I doubt you can find under 10%. And you’d have a max of 5 years to pay that back.

On a rental property it is only 5% and you have 30 years to pay it back. Isn’t that absurd in comparison?

Advantage 3 – It Isn’t an Efficient Market

The US real estate market is pretty decent at sharing information. There are things like the MLS and clear ownership through deeds.

But it isn’t perfect.

The main disruption to the efficiency is foreclosures. If someone can’t pay their bills, they get kicked out of the home and suddenly the bank owns the property. The bank doesn’t want to own a rental property (see #5 for why), so they get rid of it as fast as possible at a discount.

Other disruptions are properties that require a lot of work, which limits the willing buyers and drops the price even more than the repairs will cost. Or people who for whatever reason don’t want to go through the long 60+ day regular process of selling a home and want to unload it for cash now.

There are people more than willing take advantage of this. They put in the work to discover the deals, do the repairs, and flip it to someone like me.

Thanks to the inefficiencies in the market, everyone is happy!

Advantage 4 – Patience is Rewarded

The time frame of most investments is incredibly short.

The stock market is all about quarterly earnings. The long-term investment firms of VC and private equity are max 7 years.

Yet you are building wealth to retire decades from now.

Is that an advantage? Perhaps, especially if it keeps others away.

The expected return after 1 year of a rental property is likely negative, considering the closing costs and tenant placement expenses. It just isn’t a good option to exit the investment after 1 year.

After 5 years? Maybe. But that might be more of a crap shoot on market timing and the transaction costs are still a significant chunk of the profits.

You really have to be in it for the long-haul and willing to ride out the whole cycle.

I bet you can – aren’t you investing in a 401k or IRA that you can’t touch until you are 59.5?

Advantage 5 – It’s Small Bananas

If you remember only one advantage, this is the one.

Sophisticated investors take advantage of market inefficiencies and use them to their advantage.

The return vs effort on single family home investments is great for your personal portfolio, but insignificant for a large fund with millions of dollars.

It takes too much effort that makes it impossible to invest their entire fund in rental properties. And even if they can get a 30% return on just 1% of their portfolio, that still isn’t worth their effort.

A big shot portfolio manager won’t spend his time picking up pennies, even if it is free money.

It just doesn’t scale.

Perhaps it was a little disingenuous of me to show a chart earlier climbing 25% per year all the way to $8M. When you have over say $500k invested, the simple single family home strategy will have to change. The potential returns are lowered when leverage is reduced.

What a great problem to look forward to!

Don’t Take My Word For It, Calculate

I hope this article makes you reconsider your assumption that the risk is priced in rental properties’ amazing returns.

We looked at 5 potential advantages that you have, even if it is an efficient market.

But we didn’t put numbers to it. How much of the return is simply the priced risk? How much of it is market inefficiencies?

In Part 2 I am going to run some numbers to try to answer that question.

Yet it won’t matter one smidgen if you don’t first believe:

The stakes are important enough for you to spend brainpower on this

There are theoretically advantages you have even without any real estate experience

So let’s discuss – leave a comment below and let me know what you think.

Just look at Anakin Skywalker. He learned the power of The Force and was a straight A student. But he took that information and drew the wrong conclusion from it. Make a few bad decisions and before you know it, you are Darth Vader.

I guess Star Wars is on my mind…

I’m reading Evicted: Poverty and Profit in the American City which tells the stories of the poorest tenants in Milwaukee. But is also interestingly tells the story of the landlords – who are these people and how does it work being a landlord of the poor?

Let’s make sure we use this information for good.

You Don’t Have to Landlord!

This is the number one thing I want to shout out to people.

Investing in rental properties does not mean you have to be a landlord – separate those in your mind!

So so sooooo many people delay or decide not to invest in rental properties because they don’t want to deal with tenants. YOU DON’T HAVE TO – YOU CAN PAY SOMEONE ELSE TO DO IT FOR YOU!

If more people understood that, more would take action and benefit from the incredible returns in rental property investing.

So when we learn more about being a landlord, don’t put yourself in the landlord’s shoes and think “I don’t want to do that”.

Use it as information about the role of professional landlords. Appreciate how difficult it is dealing with tenants and how there are big differences between good and bad landlords.

Many Different Price Points Are Possible

These would be the ones you purchase for $40k move-in-ready and rent for $550 a month. Great ratios, more issues.

The book goes to show that you can make money that way.

Cartman has the correct response to this info: “wha-eva – I’ll do what I want!”

That’s not the only way to get a return. The properties I discuss are quite different: B- minimum, $80k+ that rent for $850+ a month.

The number one way to reduce tenant issues? Buy properties that attract better tenants.

The typical tenant in the C class property makes $20-30k a year and relies a lot on government programs. They jump from odd job to odd job and putting food on the table each week is far from a given. (The book even goes into more C- “slum-lording” territory where the only income of $10-15k a year comes from the government.)

The typical tenant in the B- class property makes $40k a year and has a much more steady job. Not incredible career opportunities nor a ton of job security, but certainly employable.

Which one do you want to rent to?

Some Lessons from the Book

Give an inch and they’ll take a mile.

If every day is a struggle, you are willing to cut some people down to feed your kids. That’s the cold hard truth.

Rent is by far their biggest expense so often their landlord becomes yet another victim in the struggle.

If a landlord allows a partial payment once, it will happen regularly.

If the tenant is planning on moving out, good luck collecting any more rent. They know the only option the landlord has is evicting them, which they are going to move anyways and takes time. Free rent for a while!

But by far my largest learning from the book is how ineffective communication is between the landlord and tenant. Wow it is bad.

Zero hope of phone or any type of digital communication. The landlord has to go in person often to collect rent, pounding on the door until they finally open.

No proactive communication about an issue. An incredible number of the issues are minor and could be solved pretty painlessly. But it sure doesn’t happen.

Maybe the tenant is waiting for a broken window to be fixed and doesn’t pay the rent waiting for it to be fixed first. It leads to an eviction and fixed window for the new tenant.

Maybe they pay for something or do some work on the property and decide to deduct it from the rent. The landlord doesn’t see it that way and thinks they are paying short.

Communicate, communicate, communicate.

Interesting Read, but Draw the Right Conclusions

You can learn from the landlords of the poor, but make sure you learn the right things.

Gen Y Finance Guy is an awesome website all about young person finances. I’m very grateful they shared my story when I first launched my website. Since many of you haven’t read it yet, here it is!

I’ve always looked at things a bit differently than most, somehow devoid of the fear of looking stupid by going against the crowd.

Five years ago, at the age of 25, I quit my well-paying Silicon Valley tech job and blasted out this email to everyone I knew:

Have you ever been to a wild and crazy retirement party? Well this Friday night is your chance – we are celebrating the fact that it is my last day of work and throwing an ABBA themed retirement bash.

That’s right – a party featuring all ABBA music. Gems like Dancing Queen, Take a Chance on Me, Fernando, and Waterloo (you can look forward to both the English and Swedish versions).

It was a good time, although I could tell by the 2nd hour of ABBA not everyone was as into the music as I was…

That one action (leaving my job, not throwing an ABBA retirement party) put me on the path to financial freedom. I’m not there yet, but getting started is the hardest part.

Today I am a small business owner in an area I’m passionate about and building passive income through investing in out-of-state rental properties.

Where My Journey Began

Some people are born on third base and go through life thinking they hit a triple
-Barry Switzer

This quote struck me the first time I heard it. And not just because I love baseball.

Across the landscape of financial blogs there are people in many different positions, from broke to rich. If you are signed up for the Gen Y email list you know the hardships he had to overcome to get where he is today. Others are riddled with student loan debt that will take decades to repay. Then there are a few with millions in net worth.

I feel very fortunate to start my journey in an excellent position – I won the genetic lottery with a loving upper-middle class family in California suburbia. You could say I was born on third base.

Rather, I prefer to think of it this way: the ball was hit to the deepest part of the ballpark for me, all I had to do was hustle my way around the bases to get to third. There are many people who have the same advantages and decide to coast into second base.

The goal is to make it all the way to home plate though: financial freedom. Reaching third base is worth zero runs.

The Working World

I entered the workforce in 2008 with an engineering degree from Stanford and no student loans. Terrific starting position.

Silicon Valley is the place to be for tech jobs and I landed a role at an enterprise software company. Making pretty decent money too.

I just couldn’t imagine staying there forever. Or any company really. It’s so slow! I just don’t enjoy small talk around the water cooler. Keep doing this another thirty to forty years? No thank you.

After three years I knew the gig was up – it was time for me to move on to the next thing.

The 4 Hour Workweek has a chapter about mini-retirements. It challenges the idea of waiting until 65 for a traditional retirement and proposes an alternative. Some call it a sabbatical – every few years taking several months off.

I knew if I was going to be finding a new job anyway, this would be a perfect opportunity to see the world.

So I quit, threw an ABBA party, moved out of my apartment, and started a new journey.

The Second Chapter

After traveling for 5 months, mostly in New Zealand, it was back to reality. I would have to work again eventually. The first retirement wasn’t meant to last.

But I got to thinking – if I don’t like the traditional workplace, it should be a fall back option, not the primary goal. This employment gap might be the best chance I have to start my own small business and work for myself in an area I’m passionate about.

It would mean going through a tough period with very little income, but if successful, I’d be in a much better position in the long run.

And if it didn’t work, at least I’d be able to go back to traditional employment knowing that I’d given it my all. No second guessing, wondering if there was a better way to make a living.

But What About Financial Freedom?

If I’m currently on third base, how do I reach home plate? My plan to get there is through passive income.

There is more than one path to financial freedom. Some recommend cutting expenses by doing things like making your own deodorant or getting your ketchup from the free packets at McDonald’s. Most advocate saving a huge chunk of money and reaching a certain account balance before retiring and living off a small percentage per year.

I want money to keep coming in and to be able to spend. I know I haven’t reached my peak spending years yet and don’t want to sit at home hoarding pennies.

Unfortunately there isn’t exactly a clear path that works for everyone. It is hard – you have to invest either time or money up front. It is also uncertain – your plan for riches might be a complete bust. Most people suck at rebounding from failure and never try again.

I believe it’s easiest to start earning passive income by investing both your money and your time.

Put your money to work because there is less competition – everyone wants passive income streams that require $0, so those methods are highly competitive. Instead invest your time in finding a better way to put your money to work and learn how to do it.

Which Led Me to Rental Property Investing

Rental properties are a proven way to build both wealth and passive income. You purchase a property and a tenant pays you every month – if you do it right, substantially more than your expenses. Meanwhile the property is appreciating, the tenant is paying down the mortgage, and you get tax benefits. Most people don’t consider all 5 components of return for rental properties.

The world of real estate is huge. There are thousands of gurus preaching hundreds of different ways to do things. There are expensive courses, workshops, and conferences. It is all very intimidating.

Yet the majority of failures are those who don’t get started at all. They worry over details and worst case scenarios “my cousin’s next door neighbor has a rental property where the tenant didn’t pay rent and used the bathtub as a toilet”.

They over analyze rather than taking a less than 100% perfect step 1. So how do you simplify step 1?

My Plan

I am starting with turnkey rental properties on the other side of the country. I live in San Francisco, which is too expensive for rental numbers to work. You want the rent each month to be at least 1/100th of the purchase price. In San Francisco it is closer to 1/300th.

Turnkey is when a company does a lot of the work for you. They buy distressed properties, fix them up, put a tenant in place, then sell the property to an investor. In the end you own the property and the turnkey company makes a profit for their work – their model is flipping homes, mine is holding for the long term benefits.

I hire professional property managers to take care of most the on-going work. That allows it to be passive income, not a second job as a landlord.

Right now my typical deal might have a $100k purchase price, requiring 20% down plus closing costs for an initial investment of $23k. The property rents for $1k per month, and after all projected expenses, it will provide $150 per month in cash flow.

My Advice

Research rental property investing and consider if it will help you reach financial freedom. It’s not for everyone and there are always risks when doing something different. I write about my own personal journey and how I reduce my risk at Rental Mindset.

The number one book to for motivation is Rich Dad, Poor Dad. It will drive home the goal of passive income through rental properties. Don’t expect to ever find a perfect how-to guide, there are some things you will have to figure out on your own.

Even if rental properties aren’t your thing, find a way to add passive income streams that you control. There are many ways to go about it and as you level-up your game, you will recognize more and more opportunities around you.

Next is the neighborhood. Again, if the neighborhood I’m already in still makes sense, that’s where I’m going to begin my search. This isn’t as important because property managers usually operate across the whole city, but if I move to a smaller mom-and-pop company, location within the city will matter to them.

I’m Picky About the Rehabber

For someone doing passive out of state investing, the turnkey company is extremely important. This is the company who does the rehab work on the property you purchase.

My first level of filtering is achieved by working with a company like Jason Hartman’s investor network. They have relationships with the best turnkey providers in various cities and can send a warm introduction.

I’m not a believer in doing something like Roofstock or purchasing straight from an aggregator’s website. They do a certain amount of filtering and quality control, but it is a whole lot easier to decide the rehabber you trust than it is to judge the quality of an individual property from thousands of miles away.

My preference is a turnkey provider who has been operating for 10 years at 50 to 100 rehabs a year.

Experience matters. They need a certain amount of scale to have a full time crew and know what they are doing. I want a company that wants repeat buyers, not just in it to make a quick buck.

At a certain size, maybe 10 properties a month, I fear the quality goes down. Too many other projects going on. Too specialized.

I want that sweet spot.

My Worry – I’m Not That Picky About the Property!

Once I know the rehabber, neighborhood, and rent-to-purchase price ratio I’m targeting, the particular property doesn’t matter all that much to me…

Did I just say that on the internet? What will people think?

Real estate investors are usually all about the buying. Buy low, that’s where you make the money.

They will spend months searching through deals, waiting for the perfect property. They will put in dozens of low-ball offers for every one that is accepted.

I do the opposite. I set my standards and buy quickly when something meets the requirements.

That really doesn’t match my identity put forth on Rental Mindset as an investor who gets a 31% yearly return. Am I not really a real estate investor then? Just a charlatan? Am I doing something wrong?

Maximizers vs. Satisficers

The maximizer wants the best deal possible. These are the people who go to multiple grocery stores and look up Amazon prices from the store. It doesn’t matter how good the deal is if they can get an even better deal somewhere else.

The satisficer looks until they find a deal that meets their requirements. Their criteria are more modest. They buy knowing full well there might be a better deal elsewhere. They say this and move on:

If a maximizer and satisficer are shopping for the same thing, the maximizer will get the better deal.

It is apparent that the maximizer also paid a greater cost in terms of time. Depending upon how you value your time, this alone might tip the balance towards satisficers being the overall better decision makers.

But wait there’s more.

The maximizers got the better deal, but who is happier about the decision? Satisficers.

The maximizers are more likely to have buyer’s remorse. Even after they buy, they continue to comparison shop. Not just for a better deal on the item, but what else could they have used that money for?

But wait there’s more.

Decision fatigue is a real phenomenon – the more decisions you make, the worse they get.

So if you put a ton of cognitive load into comparison shopping laundry detergent, you are more likely to snap at your kids or fire off that snarky email to your annoying coworker.

The book helped me stop trying to maximize every decision. If you are cheap, check it out.

Satisficing on a Rental Property

The turnkey approach isn’t really for maximizers. There are always better deals out there if you put in more work, including finding the deal and rehabbing it.

Some people are interested in the more passive nature of turnkey investing, but have a mental block paying market rate for a house when discounts are available elsewhere.

They take issue with the turnkey provider making a profit off of them. Why should someone make $15k off flipping a property to them? Shouldn’t they shop around and find someone willing to do it for less?

I am firmly in the satisficer camp on this one. It is ok if the turnkey provider makes money as long as I get a good enough deal (what constitutes a good enough deal changes over time).

What do you think is the right approach here?

Is my lack of pickiness about the particular rental property actually a better decision making process?

Am I really a real estate investor if I’m not hunting out the best deal for months?